Banking

Investors may not remain sweet on CoCo bonds

Lloyds bondholders agree to swap, but other banks could struggle

By

SimonKennedy

LONDON (MarketWatch) -- It looks like plain sailing for Lloyds Banking Group's capital-raising plans after strong investor demand for its innovative CoCo bond issue, but other banks with similar plans may find the market isn't so sweet on a deal.

The U.K. group said Monday that bond holders had snapped up an offer to exchange their existing notes for the CoCo -- or contingent convertible -- bonds. Indeed, demand has been so strong that the bank has expanded its original plan.

On Tuesday it also priced the rights issue side of its plan, which in total is intended to raise around 22.5 billion pounds ($37.3 billion). The successful bond swap and terms of the rights issue pushed Lloyds shares up nearly 6% in the first two sessions of the week. See story on Lloyds rights issue.

The bonds work like a normal fixed-income investment unless the bank gets into trouble and its core Tier 1 capital level falls below 5%. In that event, the bonds automatically convert into common stock, providing an immediate boost to the bank's capital levels and saving it from disaster.

At least, that's the theory.

But analysts and investors are skeptical both about how effective the bonds could be in supporting a troubled bank and whether there would be enough demand if another firm tried to sell them.

Niche market

"Given discussions we've had with quite a few investors, there may be a market, but it will be kind of a niche market," said Johannes Wassenberg, managing director of the financial institutions group at Moody's Investors Service.

He said the structure of the bonds is ideal for the bank, and for regulators, but not for investors, who would find themselves holdings equity at the worst possible time.

There's a fear that the rush for the exit as bond investors try to sell their newly-created equity stakes could even accelerate the difficulties of a bank, adding further pressure to its stock price and further negative publicity over its finances, he said.

So if there are so many concerns over CoCo bonds, how was Lloyds (LLOY)
LYG, -1.57%
able to generate such demand?

The simple answer is that the offer was structured so investors would be foolish to refuse.

The deal offered the new bonds, at a higher interest rate, in exchange for notes that were already impaired. And investors who decided not to swap risked not getting any interest payments for the next two years because the European Commission has blocked the payments on lower-ranked debt.

However, if another bank were to try and sell similar bonds for cash it may struggle to attract enough demand.

Inconsistencies

Ben Lord, a fund manager at M&G Investments, said in a recent blog post that the bonds generate a "plethora of problems and inconsistencies" and that they "don't naturally fit into the fixed income universe."

"It seems to us that regulators are being overly accommodative to get this deal done, and to help recapitalize Lloyds," Lord said.

He added, however, that the yields do look attractive and that M&G would consider buying CoCo bonds from stronger banks where they feel the risk of a conversion into equity is sufficiently low.

No other banks have yet announced plans to use CoCo bonds, but there are several that do need to raise more capital or that are still negotiating restructuring plans with the European Commission.

Wassenberg said the Irish banks, such as Bank of Ireland (BIR)
IRE, -1.24%
and Allied Irish Banks (AIB)
AIB, +0.78%
could be candidates. Another issuer could be the Royal Bank of Scotland (RBS)
RBS, -1.96%
which is still finalizing its restructuring plans with European authorities.

One group that won't be buying the Lloyds notes, or any others, are index-tracking bond funds after the Association of British Insurers successfully lobbied for the notes to be kept out of the main indexes operated by Bank of America Merrill Lynch.

The ABI argued that tracker funds would be forced to buy the bonds if they were included in indexes. But many of these funds are forbidden from holding equity. So if the bonds converted, the funds would be immediately forced to offload the stock into a sinking market.

Some of those funds do already hold other types of convertible bonds, but they generally give the holder choice over whether to exchange. They also generally convert into preference shares, which are often more like a bond investment, while CoCo bonds convert into common stock.

Trigger levels

Standard & Poor's credit analyst Michelle Brennan said CoCo bonds should be seen as an emergency tool but not as a way of addressing banks' existing weak balance sheets.

One of the main practical difficulties will be whether the bonds will convert into capital early enough to actually help the bank, Brennan said in a recent report.

It's difficult to determine what the right trigger level will be before a crisis hits, and capital ratios at different banks aren't even totally comparable because they can be calculated in slightly different ways.

Moody's Wassenberg said an example of this potential problem occurred during the financial crisis.

Even as the government was pumping billions of pounds of state aid into the sector, Wassenberg said he wasn't aware of any firm that actually reported a core Tier 1 capital level below 5%.

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